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Understanding the European Debt Crisis

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We have seen in these last weeks a lot of contradictory messages regarding the European Debt Crisis. Actually, the situation that seems desperate is even more critical than what some European leaders may want to tell us.

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									Understanding
the European
Debt Crisis
We have seen in these last weeks a lot of contradictory messages regarding the
European Debt Crisis. Actually, the situation that seems desperate is even more
critical than what some European leaders may want to tell us.

It is understandable that politicians hide critical information from the market to
prevent increasing instability. But the facts are proving that half-baked solutions will
not save Euro and European economies. The performance of sovereign bonds in the
Euro zone is below sustainable. Recently, Italy has raised 3 billion euros at record
rates adjudication. Even the spread between the Belgium bonds and its German
counterpart, most stable European economies have gone beyond historic highs. Now
markets are looking to France that may lose its AAA.

But before getting to conclusions on the origin of this crisis and its solutions let us first
introduce key tools that will help us understand the situation as we are facing it today.

The bonds selling process
Countries in need will have to find cash to keep their economies working and to
provide money to its different departments. They may take loans but the best interest
rates are found when they issue their own bonds. That if their situation is stable and if
the market give credibility to the country ability to pay back at the end of the defined
period. Many different parameters will help to fix the rate of these bonds: Risk, law of
supply and demand and of course ratings fixed by rating agencies…

Bonds are issued on the market but can only be bought by finance operators, which
are banks, insurance companies, funds and of course other countries…

The Yield
Law of supply and demand is fixing the prices on stock markets: Plain and simple,
more people buy a share, more its price raises.

The same laws apply to the bond market. The difference is that bonds are listed in
percentage of their nominal value and their rates are fixed when they are issued. If
investors decide to sell these bonds, the percentage related to the bonds will go
down and then the yield will go up.

For example if a 100% odds 1,000 euros bond has an accrued interest of 10%, this
will mean that its yield is 10%.

If this same bond has 90% odds (it is only worth 900 euros on the market) the
accrued interest stays at 10% of the issue price (100 euros) its yield becomes 11.1%.

Long story short, more the market will find that the risk gets higher, more the trend
will go for selling, more the bonds value will go down and more the yield will go up.
The Spread

The Spread gives an idea of the difference that we have between two types of bonds.
Still, when we are talking about European bonds, the Spread will refer to the
comparison between the rates of a 10 years bond of some European country and the
German Bund. (Germany is the strongest economy in Europe and its bonds are a
reference there)

The principle is quite simple, more limited is the Spread, better it is for the selected
country. Two years ago the Spread for Belgium was 32 basis points, this month it has
reached a 300 high basis point. This means that Belgium will have to spend more
money while issuing its bonds and that is far better compared to PIGS countries…

To give you an idea about the evolution of the crisis these last months there is the
details (Bloomberg) for the Belgium-Germany Spread.




The Haircut
This technical word refers to the below par rating or the drop in the valuation of
bonds. It means that the institutions that have bought some bonds will have to accept
less valuation. It happened recently in the case of Banks that have invested into
Greek bonds. They have lost 50% of expected value, since they “accepted” 50%
haircut.

This was necessary to save Greece. But it won’t save it. Still, no one would cry for
the bankers, they have bought these risky bonds at much higher rates than those
based on the Spread.
THE CREDIT DEFAULT SWAPS
CDS are some kind of insurances that help bonds buyers to protect themselves
against the risk of non-payment of a company or a state. These CDS can be very
high even for stable countries like Belgium. In this last case, to ensure 10 million
euros 5 years bond investment, a bank has to pay a premium of 340.000 euros at
340 basis points.

The situation is of course worse for PIGS countries. There is a chart giving basis
points for some European countries. (Notice that Greece is not even in the list)




Such insurances are one of the main reasons of the debt crisis. Banks are investing
in “protected” bonds and taking huge risks but the worst part is that it is still possible
(at least until the first December 2011) to trade CDS without having the underlying
bonds. This can be something close from the crisis generated by subprimes.

THE ORIGINS
J-C Trichet former President of the European Central Bank stated in one of his last
interviews that the Euro Zone was in far better shape than US and UK. This may be
true, but the Euro zone doesn’t have a federal economic system and it is unlikely that
the markets may see it as one entity. Actually, it is all the opposite, the markets are
segregating between countries.

The markets are making a mistake on that because dropping Euro is not even an
option for key European countries. It may look like a possibility but this would just
blow all European economies starting with the German one. But anyone that would
ask the markets to think wisely before speculating and shorting positions is either
crazy or fool. It seems like European politicians are in one of these categories.
The markets are asking for guaranties not empty words and the only guaranties that
may work are unified Euro-bonds and unified economic government. Still, the
Germans are against the principle of Euro-bonds, simply because it will make them
pay more interests on their own bonds emissions and will tie their economy to
unhealthy PIGS economies. In simple words, saving Europe will hurt German
Economy.

The problem started even before the creation of Euro. Europe never made any effort
to create a real politic union and even less a homogenous economic federalism. They
have decided to postpone any decision on that after the launch of Euro as unique
currency for most European countries but they forgot about it completely until this
recent crisis: So countries kept borrowing money and issuing bonds counting on the
European Central Bank credibility to guarantee them the lowest possible rates.

No one tried to control the debt limits for each country of the Euro Zone. The
European Central Bank should have issued warnings for countries that were not
respecting the Euro treaty terms but this would have been a serious political decision
and most countries were bad behaving.

Greece continuously borrowed money without adopting any kind of economic reforms
to limit the impact of the debt on its revenue. Today, the debt is at a highest 140% of
the country’s GDP and represents a 14% burden on its revenue which is dramatically
high for such weak economy.

The problem gets worse when this same Greece is talking about leaving the Euro
Zone. No one would think about the possibility of Texas dropping the Dollar as a
currency. This political instability gives the markets a reason to ask more guarantees
from the EU. So, even if USA is in a bad shape it is still a real federal and monetary
union and the markets give the FED far more credibility on solving the debt problem
in the US.

Euro zone countries had to prepare for such cases and to prepare rainy day funds to
face markets instability as stated in the Euro pact. Again, no one respect that and we
ended up in a situation where France and Germany had to borrow money to lend it to
Greece at higher rates, adding more burden on the frail strangled economy.

The second problem came from the private debt. Companies and households in
Spain and Ireland had huge excess debt and no savings. So after the housing bubble
burst the whole country economy just collapsed because the states were relying so
much on taxes linked to these sectors. This private debt ended up as country debt
since states had to face unemployment and lack of financial resources.

The third problem was in fact this cacophony and contradictory statements from all
the European actors. They have lost a lot of time negotiating and discussing potential
solutions when those had to be set up at the creation of the Euro. The situation
ended up out of control and Europe one of the greatest economies of this planet had
to accept the help of the IMF to save Greece.

The forth problem is in fact the inability of Greece to reimburse its debts. Stopping the
spending and asking Greeks to pay more taxes and accept more cuts will only make
the situation worse than it is right now. It is killing completely the growth mechanisms
and is increasing unemployment and despair among citizens.

Without any growth there is no chance that Greece or any other European country in
the same situation to face its debt, so even less chance to stop it from getting out of
control. And the 440 billion crisis fund created by Europe to help countries that are
unable to face such situations won’t be enough if Portugal (and even more Spain or
Italy) had problems to repay its debts.

THE SOLUTIONS
In fact there is only one solution, Germany has to accept Euro Bonds and Brussels is
asking for it day and night. This could seem unfair but the first European Economy is
making most of its trade surplus in Europe (85% of it!). This means that Germany
used other European countries spending to get stronger.

We could not say that Germany stole the money from its partners but they have to
accept Euro-bonds for the time being. Otherwise its own economy may suffer greatly
if other European countries fall into perpetual debt crisis.

But more importantly, Europe has to create a superior European minister of
economy. He should oversee all European economies and define the future rules of
the Euro Zone. It is mandatory for the EU to define a unique and unified strategy and
to speak with one voice to the markets.

Giving too many signals and talking about the possibility of expelling Greece or letting
it go out of the Euro has been one of the worse political and economic decisions of
Europe. This has cost millions if not billions to the poor Greeks.

This kind of situations is unacceptable. Europe has to prepare new mechanism to
control its member economies and to limit unwise expenditures. This would be the
only way for the members to get access to Euro Bonds and to its low rates.

One last point, right now France and Germany are stopping all expenditures and
asking other members to freeze their investment efforts. Of course, this is a way to
slow down the debt inflation, but this is creating unemployment and slowing growth
rate. Instead of blocking all investments, countries should instead use Euro Bonds
and equities gathered for privatizations to invest into new industries and innovations
that could bring high return rates and employment.

There is no miracle. Times will be tough for all European countries but also for other
economies. If the situation continues getting worse, even China and all Asia may
suffer from the fading European purchasing power. Something has to be done and
fast, otherwise the whole World Economy may face the greatest crisis since 1929.




REFERENCES
+ Graphic: European debt crisis explained
http://www.telegraph.co.uk/news/interactive-graphics/graphic-of-the-
day/8868729/Graphic-European-debt-crisis-explained.html



+ EU Commission sees eurobonds as way out of crisis
http://www.miamiherald.com/2011/11/21/2512326/eu-study-eurobonds-best-way-
out.html

+ EU Pushes Scenarios for Euro Bond
http://online.wsj.com/article/SB10001424052970203710704577050360748379688.ht
ml?mod=googlenews_wsj

+ European Debt Crisis Timeline
http://online.wsj.com/public/resources/documents/info-EZdebt0210.html

+ Greece in crisis: How European debt problems affect you
http://www.bbc.co.uk/newsbeat/15540394


+ J.P. Morgan Uses Lego Minifigs to Explain European Debt Crisis
http://www.wired.com/geekdad/2011/09/jpmorgan/

+ European debt crisis: Explained in SIMPLE terms
http://www.rediff.com/business/slide-show/slide-show-1-all-about-european-debt-
crisis-in-simple-terms/20110819.htm

+ The European Sovereign Debt Crisis Explained: Greece & Co

http://www.mymoneycalculator.com.au/news/2011/09/the-european-sovereign-debt-
crisis-explained-greece-and-co/

								
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